Understanding the New Zealand exchange rate

Release date

22 November 2013

Addressing underlying imbalances in
the New Zealand economy is the key to addressing New Zealand's overvalued
exchange rate, Reserve Bank Assistant Governor and Head of Economics Dr John
McDermott said today.

"The nominal exchange rate is currently at
historically high levels against nearly all of our trading partners. The real
exchange rate – which takes into account relative inflation rates and so
is a better measure of overall competitiveness – is also at historically
high levels."

Dr McDermott said that much of the New Zealand dollar's current
strength can be explained by factors such as New Zealand's current high
terms of trade, especially dairy prices, and relatively strong economic
performance.

"However, the Reserve Bank believes that, from a long-term perspective,
the exchange rate is overvalued. The high exchange rate is contributing to
economic imbalances and the Reserve Bank would like to see it lower in order to
promote more sustainable economic growth.

"Whether the exchange rate is overvalued from a long-term perspective
relates to the effects it has on real economic outcomes. For instance, an
overvalued exchange rate will affect the tradable sector's profitability
and its decisions about investment, employment, and market strategy."

Dr McDermott said that commentators have provided a range of suggestions to
correct the overvaluation problem, including: keeping interest rates low;
currency intervention; quantitative easing; capping the exchange rate; and
changing the focus of monetary policy to target the exchange rate.

"Many of these suggestions are unlikely to have
a significant lasting effect on competitiveness, or would have unpalatable
trade-offs such as much higher inflation, or are simply not feasible," he
said."

Evidence in New Zealand and elsewhere suggests foreign
currency intervention is unlikely to have a sustained impact in lowering the
exchange rate.

"Saying there is little monetary policy can do
about the exchange rate, however, is not the same as saying there is little that
can be done."

Dr McDermott said that a lack of flexibility in other
parts of the economy means that the exchange rate can overshoot where it should
be in the long run.

"For instance, microeconomic policies can promote greater competition
and remove roadblocks to the reallocation of resources in response to market
signals. Such policies would reduce the need for the exchange rate to carry the
burden of absorbing economic shocks. An example here could be increasing the
responsiveness of the building industry to housing demand.

"Likewise, reducing the magnitude of domestic demand cycles would
reduce the pressures that monetary policy needs to lean against. This includes
avoiding pro-cyclical changes in fiscal policy such as tax cuts or increasing
public spending when resources are already stretched, or deterring banks from
excessively relaxing credit standards when demand for financing is strong. Such
actions will ease cyclical exchange rate pressures."

However, for a sustained reduction in the exchange
rate, it is necessary to alter the level and pattern of saving and investment,
in particular New Zealand's reliance on foreign savings to finance our
consumption and investment, Dr McDermott said.

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